Economist, Telegraph Columnist, Broadcaster

Italy has won this euro battle, but not the war

Long-suffering investors, desperate for some good news, have seized on the headlines from the latest in a long series of “last-ditch” European summits.
In Brussels on Friday, Angela Merkel certainly indicated some concessions on the use of collective eurozone bail-out funds to address soaring Spanish and Italian sovereign borrowing costs.

The German Chancellor, the argument goes, has “finally capitulated”, now agreeing to back-stop the banking sector debts – and, therefore, the worst of the sovereign debts – of the single currency’s profligate “Club Med” members. And so, we’re told, the eurozone will is now headed for the sun-lit uplands of stability and policy coherence.

There was enough oomph behind this view – or at least enough “angst-fatigue” – to launch another relief rally. The main Italian, Spanish and Greek equity indices surged 5-7pc, with Franco-German bourses going along for the ride. In London, even the FTSE-100 rose 1.4pc on the eurozone’s love-in, despite shocking news about the UK’s banking sector. This Libor rate-fix should sear itself into the British psyche, causing as much shame and outrage as Watergate.

Just as the exposure of blatant criminal activity among top political operatives led to serious heads rolling in mid-1970s America, so revelations of yet more willful wrong-doing among our own “commercial elite” should bring very big changes in the way we run our financial services industry. But more of that later. Because the news from Brussles also warrants attention.

Merkel was apparently forced into a humiliating volte face, after being “ambushed” by France, Italy and Spain. The new “Latin Alliance” clearly engaged in some rather energetic posturing, threatening to block any pan-European deal unless Germany, Finland and the other “eurozone solvents” granted easier access to bail-out funds.

The German government has now agreed, in principle, that the fiscal retrogrades can use central eurozone finance to re-capitalize banks or buy bonds directly, without adding to already fragile government balance sheets. In response, Merkel’s political opponents in Berlin accused her of executing a “180-degree turn”.

It is abundantly clear, though, to any objective observer, that there is a very long way to go before any kind of resolution. Strict conditions still apply to the use of eurozone rescue finance. The exasperated German Parliament retains a veto over the deployment of such funds. And the entire notion of direct funding to member-states’ banks, as oppose to respective sovereigns, still needs to be cleared by Germany’s Constitutional Court.

As such, we could yet see this famously nit-picking and powerful judicial body only granting approval following a referendum – which would be the first in Germany’s post-war history. On current evidence, the country’s hard-working population – widely disgusted by the idea of bail-outs, however much the older generation want to be seen as “good Europeans” – could well say “nein”.

In theory, Friday’s deal means Spanish banks will receive €100bn (£81bn) in funding, first from the European Financial Stability Fund and then its replacement, the European Stability Mechanism. ESM bonds will also concede seniority over ordinary creditors, addressing another market concern. Italian banks, too, may be eligible for such support – but no-one knows for certain. Even that massive issue, though, is dwarfed by other unknowns.

The Brussels proposals, even before they face approval by Germany’s constitutional court and any number of other national Parliaments and judicial bodies, are still a long way from being agreed in and of themselves. Euro-area finance chiefs are due to hammer out the details between now and 9th July.

Can any terms really be found for the direct recapitalization of Spanish banks which are acceptable to both the Madrid government and the German Parliament? Berlin will want to wipe-out existing bank shareholders and creditors while the Spaniards will want to protect them. And according to the Brussels summit communiqué, the bail-out can, anyway, only happen once a eurozone-wide bank regulator has been “established”.

Mindful of the massive rows that the Spanish bank bail-out will yet provoke, to say nothing of squabbles over the powers of the new bank regulator itself, the founding of this crucial institution – without which direct bank bail-outs remain a pipedream – is only to be “considered” before the end of 2012. Such language is hardly a call to action. It is indicative, surely, of a situation involving merely a slither of common ground.

Then there’s the question of the bail-outs funds themselves, whatever the mechanism for their actual delivery. German Finance Minister Walter Schauble has said, unequivocally, that there will be no increase in the size of the ESM – a position Merkel confirmed in Brussels. In addition, the German Chancellor re-iterated, for about the twentieth time, that “joint financing” of eurozone debt won’t happen before the foundation of some future “full fiscal union” – an outcome which many people, including this columnist, believe is the stuff of political, logistic and cultural fantasy.

In the here and now, in terms of bringing European markets back from the brink in the weeks and months to come, Merkel was absolutely correct when she pointed out that Germany took on “no joint liabilities” in Brussels. And this, precisely, is why the bond markets, more sanguine than their equity-trading cousins, have been singularly under-whelmed by this summit. The yield on 10-year Spanish debt remains north of 6.5pc, still totally unsustainable and well-within the sovereign bail-out danger zone.

The first sentence of the Brussels communiqué states that European governments “affirm that it is imperative to break the vicious circle between banks and sovereigns”. Amen to that. Around the eurozone’s neck continues to sit the crippling bank-sovereign “doom loop”. Debt-soaked banks are dragging down fiscally-precarious states, the resulting high yields then stymieing growth, making bank balance sheets look even worse.

The circle will only be broken, of course, once politically-connected banks are busted up, their creditors being forced to take losses. This has yet to happen in Western Europe – and, until it does, we’ll keep lurching from crisis to crisis.

And then there is the UK. Last Wednesday, Barclays was fined £290m for conspiring to fix global interest rates. The manipulation of Libor has cost consumers, businesses and investors tens of billions of pounds. Although Britain sits smugly outside the eurozone, our banking predicament is even worse. Why? Because the UK’s banking sector is absolute enormous, with balance sheets totaling more than 4 and a half times’ annual GDP. In proportionate terms, this is over 7 times the size of all US banks.

Amidst a growing sense of national outrage, David Cameron says that addressing the Libor scandal is “frankly, as vital as dealing with the unsustainable debts left by the last government”. It is not “as vital”, Prime Minister. It’s part of the very same problem.

Britain’s banks are, quite clearly, out of control. The government hasn’t even got the guts to implement the extremely weak “Vickers reform” – which supposedly set up a firewall between investment and commercial banking. Well, history shows that firewalls don’t work, which is why we desperately need a proper “Glass-Steagall” split. Unless we get one, then the on-going use of ordinary deposits to finance investment bankers’ bets will result in yet more UK bank bail-outs. Given the rescues we’ve seen so far, and the gargantuan size of our bloated banking sector, this is something the UK simply can’t afford.

If the combination of the eurozone “doom-loop” and “Libor-gate” aren’t enough to galvanise our politicians into imposing genuine banking reform, then I really do despair for the future of my native country.